Value investing, stock market advice and online trading blog – Roger Montgomery Insights blog

Investor Point:  Andrew observes that companies in fast changing industries are prone to misguided adventures with shareholders funds after they mature (which they do very quickly in a country with a population of a mere 23 million).

(if you’d like to contribute a post send it to roger@rogermontgomery.com with the word CONTRIBUTION in the subject line)

The internet list companies have long been considered favourites of some of the community here (including myself). Their ability to generate lots of free cash and earnings against very little equity makes them prime considerations as a company some would like to own, especially as some have great competitive moats around them. However, is there an inherent risk that needs to be considered and compensated for when choosing to value and/or invest in these companies? This is a question I have been considering as of late and would like some help to answer.

Valuing companies is a forward looking exercise and so we must make certain decisions and adjustments based on how we think this company will grow over the years.

A company must be able to earn attractive rates of return on the incremental capital it puts to work. As a company moves further along on its life cycle this gets harder to do. When a company reaches maturity, earning these attractive returns becomes even more difficult and organic growth opportunities dry up. A company must then look for other avenues of growth and/or use its capital wisely to increase shareholder value whether it’s through increased dividends or share buy backs.

Usually a company can grow organically by opening up new stores for example, however you cannot do this on the internet. This lack of organic growth opportunities causes the growth stage of the business to be shorter and therefore the maturity stage to come around in a quicker timeframe than a tangible business. The lack of costs needed to operate this kind of business also means that when these companies reach maturity, there is very little scope to increase profits by becoming leaner.

This only leaves the option of new product offerings, purchased growth (M&A) and/or offshore expansion as the remaining avenues for growth. All of these options have risk to both the company and investor and could see real damage done to the return on equity of the business if not done well (for example paying too much for another company).

The growth versus profitability conundrum is one that has seen many companies go down a route, which leaves the investor worse off.

It is my opinion that acquisitions cannot be seen as abnormal or opportunistic exercises for these internet businesses. They are, instead, an inevitable result of the companies journey through the life cycle and therefore needs to be considered when making investment and valuation decisions. As an investor cannot know exactly when and where this acquisition will be made nor how much it will cost until it happens it therefore clouds the waters of valuation.

As has been said many times, it is better to be conservative and wrong than optimistic than wrong and one could easily use more conservative inputs to compensate for this unknown. Another option to consider is that there is a higher implied risk for this investment and there for an investor should ask for a higher required return (higher risk premium) or seek much larger margins of safety.

The investor cannot with the same certainty be able to invest in these companies over a long-term time horizon as some other businesses as the expected life cycle of such a business is shorter and involve constant corporate activity, which will require a meaningful amount of analysis. So far the main companies (REA, SEK, WEB, CRZ, WTF) have been negotiating the path reasonably well and hopefully that continues. However, some have been especially active in purchasing growth and/or going offshore. If this continues it is my opinion that the risk becomes higher as the risk of management error (paying too much etc) becomes greater.

Posted by Andrew

Postscript:  Paying too much for the companies themselves is also possible (see valuation/price chart below for WEB)!

Posted by Andrew L with permission of Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 21 February 2012.

This piece by Satyajit Das was just sent to us and we thought it worth sharing.

Why Europe’s Plan to End the Debt Crisis Can’t and Won’t Work

The most recent summit failed to reach even the lowest expectations. Euro-Zone leaders displayed poor understanding of the problems, confused strategies, political bickering and infighting as well as inability to take decisive steps and stick to a course of actions.

The actions need to try to stabilize the European debt crisis are well recognized. Countries like Greece need to restructure its debt to reduce the amount owed – a euphemism for default. Banks suffering large losses as a result of these debt write-downs need to be stabilized by injecting new capital and ensuring access to funding to avoid insolvency.

A firewall needs to be erected to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis. Steps must be taken to return Europe to sustainable growth as soon as possible.

Even if all these measures could be implemented as soon as possible, success is not assured. But without them, the chance of a disorderly collapse is increasingly significant.

What’s Chinese for Begging Bowl

Another option proposed is to enhance the European Financial Stability Fund using resources from private and public financial institutions and investors through Special Purpose Vehicles (SPV). Few details are available currently.

The idea seems to be to raise money from emerging nations with large foreign exchange reserves, such as China, or sovereign wealth funds. The EFSF would provide the equity in the SPV with the investors providing senior debt to increase the funds capacity. The scheme appears reminiscent of leveraged investment vehicles such as collateralized debt obligations (CDOs) and Structured Investment Vehicles (SIVs).

Support for the idea amongst potential investors is uncertain. French President Sarkozy solicited Chinese support by a direct appeal to Chinese President Hu Jintao. China’s position remains guarded in the absence of additional information. The Chinese position to date has been that Europe must get its house in order first and then China will assist. The current European position is different – China must give money to Europe to get its house in order.

China has considerable “skin in this game.” Europe is China’s biggest trading partner. China has around $800-1,000 billion invested in euros and European government bonds. Continuation of the European debt problems will have serious effects on China’s economy and its investments.

The Chinese leadership also has to consider the internal political reaction to increased investment in Europe. Chinese foreign investments, including in foreign financial institutions in 2007 and 2008, have incurred losses. China’s leaders face criticism from a large section of population for having invested Chinese savings poorly. China’s officials will not want to be seen to risk even more capital on a potentially lost cause. It is not clear that the EU proposal has sufficient chances of success to encourage China increasing its exposure to Europe, especially as relatively wealthy European countries, like Germany and France, are unwilling to put up more money and are seeking to limit their exposure.

China also faces domestic problems – inflation (partly as a result of the weak currency policies of the developed nations) and attendant wage pressures that are reducing its competitiveness, serious bad debt problems in their banking system and pressure to accommodate the economic aspirations of an increasingly restive population. China’s flexibility to act may be limited.

But China seems desperate to be seen as a “global power.” Ego might seduce them into committing more money.

Contributions from China and other emerging countries will not resolve the problems. China’s contribution, expected to be around euro 70 billion, is small relative to the total requirements. As its foreign exchange reserves have risen in recent years, China has purchased substantial volumes of euro-denominated assets, both directly and via bonds issued by the EFSF, without preventing peripheral European bond yields rising. The need for this special scheme is also not clear as the Chinese can presumably invest directly if they wish to and see value in doing so.

Any Chinese involvement would probably require additional support from the Euro-zone countries, which may be opposed by Germany and other nations. China is inherently risk averse and will seek to negotiate additional political concessions, such as reducing pressure on the revaluation of the Renminbi, trade and currency sanctions and criticism on human rights issues. It is not clear whether these will be acceptable.

The negotiating stance of China is evident from its desire to denominate any funding in Renminbi. The EFSF have not ruled this out. The idea is dangerous, as Europe would incur currency risk, becoming exposed to an appreciating Renminbi, adding to its long list of problems.

The entire proposal smacks of desperation and belief in a simple, quick solution where no such option exists.

At best, the plan provides funds to tide over the immediate funding problems of weaker Euro-Zone members. It does little to deal with the Euro-Zone’s structural problems. There is still the risk that Europe enters a prolonged period of low growth or recession. The plan does not address the economic divergences that exist within the Euro-Zone or ease the painful adjustment processes that weaker members will still have to undergo within the constraints of the single currency. These problems are far more difficult to fix than the task of finding buyers for the required amount of government debt.

Balancing Imbalances

The EU refuses to deal with fundamental problems. The austerity and balanced budget measures, reinforced and reiterated in the plan, cannot deal with the primary problem – the deflation of the debt-fuelled bubble.

The EU is seeking to enforce the rarely adhered to rules for membership of the euro, the Stability and Growth Pact requires a deficit no larger than 3% in any one year and a Debt to GDP ratio no larger than 60%. Based on 2010 figures, Austria, Belgium, Cyprus, France, Ireland, Italy, Portugal, Spain and Greece do not meet one or both of these tests on current measures. Only Germany, Finland and the Netherlands are in compliance and would pass in 2013 on current projections.

Strict enforcement of this rule about deficits would prevent counter-cyclical spending by governments undermining economic recovery and lock the Euro-Zone into a death spiral of budget deficits, further budget cuts and low growth.

The problem is compounded by the competitiveness gap between Northern and Southern countries, estimated at 30% difference in costs. The EU’s refusal to contemplate a break-up or restructuring of the euro makes dealing with this problem difficult.

For many of the weaker countries, the best option would be to devalue their currency in the same way that the U.S. and Britain are debasing dollars and sterling respectively. Unable to devalue or control interest rates, these weaker countries are trapped in a vicious and ultimately self-defeating cycle of cost reduction.

An additional problem is the internal imbalances exemplified by Germany’s large intra-Euro-Zone trade surplus at the expense of deficit states, especially the Club Med countries like Greece, Portugal, Spain and Italy. German reluctance to boosting spending and imports makes any chance of resolving the crisis even more remote.

German hypocrisy, in this regard, is problematic. German banks lent money to many countries to finance exports, which benefited Germany. Germany also gained export competitiveness from a weaker euro–an exchange rate of euro 1 = U.S. $ 2.00 would be a realistic exchange rate if the euro were to be a purely German currency. Reluctance to confront these problems makes a comprehensive resolution of the crisis difficult.

Endgame

In chess, endgames require using the few pieces left on the board to achieve a result. Strategic concerns in endgames are different to those earlier in the game. The King becomes an attacking piece. Pawns become more important because of the potential to promote it to a queen. Endgames are more limited and finite than say openings.

The plan has bought time, though far less than generally assumed. As the details are analysed, weaknesses, unless remedied, will be quickly exposed.

The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidize the weaker economies); debt monetization (the ECB prints money); or sovereign defaults.

The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow the printing of money. This assumes that a cost-benefit analysis indicates that this would be less costly than a disorderly break-up of the Euro-Zone. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetization.

Unless restructuring of the euro, fiscal union and debt monetization is removed from the verboten list, sovereign defaults may be the only option available.

Regards,

Satyajit Das

And Ray Dalio’s piece will give you a terrific framework to help you understand what Satyajit is talking about, where we are, how we got here and where we are going…Click Here

Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 9 February 2012.

Click on the above IMAGE to see a larger and clearer version of the screenshot from Skaffold.

The ability to turn off and tune out the noise of the market is a key to success.  I don’t know whether the market will keep rallying amid improving US economic data in the short term while ignoring long term structural European banking and credit issues that is now ‘old news’.  I do believe that the market reacts to new ideas while always keeping an eye on old ideas.  European deterioration was new for a while and now its not.  The ‘new news’ today is that the US economy is improving.  Europe is, as I say, old news.  But old news gets recycled when the new news the short termists are focusing on becomes old news itself.  if you are keeping up, you are doing well.  One expects that eventually the appetite for stocks could weaken when news of a resurgent US becomes old and unresolved structural issues return to become news again.

Putting that aside, here is a list of six companies that popped up in Skaffold (click here to join) today when I looked for A1, A2, A3 and B1 companies trading at a better than 15% discount to estimated intrinsic value.  I then selected for no debt (net cash), forecast EPS growth and expected positive growth in estimated intrinsic value.  You will note that I have left out the names of the companies that make the grade. There’s a good reason which I will discuss in a moment…

As an aside if you would like to see how the stocks in your portfolio compare to the Skaffold universe you can CLICK HERE and enter your five stocks directly into Skaffold.  Once you have done that I imagine you won’t want to invest without it.

…To start a discussion about what is good value in the market right now, have a go at suggesting what the six stocks in the above list are.  If you can get all six right in one go, I will ask the team to send a signed copy of my book Value.able to the first correct answer.

If you simply want to discuss a value opportunity you have uncovered go ahead by clicking the Leave a Comment button below.

Posted by Roger Montgomery, Value.able and Skaffold author and Fund Manager, 6 February 2012.

Late last year the Federal Bank of San Francisco’s research department published their findings about a relationship between the ageing baby boomers and P/E ratios. I have long held the view that when Australia’s baby boomers (the majority of whom are asset rich and cash poor) reach the age that they need to fund their retirement spending and healthcare, they will need to sell their assets (typically real estate). Given the next generation have long complained of being unable to afford a house, it seems logical that prices for homes will need to fall. Only if prices fall can a generation of sellers meet the generation of buyers who say they cannot afford to pay current prices.

If that is indeed true for one asset classes then perhaps it makes sense for other asset classes. Wealthier baby boomers with DIY share portfolios will also need cash. They may not sell the family home (although downsizing is a very real trend), instead they may use their share portfolios as their ATM. This could put pressure on the multiples of earnings, sales and book values that trade in a free market.

The FRBSF seems to agree…Zheng Liu and Mark M. Spiegel discovered a strong relationship between the age distribution of the U.S. population and stock market performance.

“A key demographic trend is the aging of the baby boom generation. As they reach retirement age, they are likely to shift from buying stocks to selling their equity holdings to finance retirement. Statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades.
The baby boom generation born between 1946 and 1964 has had a large impact on the U.S. economy and will continue to do so as baby boomers gradually phase from work into retirement over the next two decades. To finance retirement, they are likely to sell off acquired assets, especially risky equities. A looming concern is that this massive sell-off might depress equity values.

Many baby boomers have already diversified their asset portfolios in preparation for retirement. Still, it is disconcerting that the retirement of the baby boom generation, which has long been expected to place downward pressure on U.S. equity values, is beginning in earnest just as the stock market is recovering from the recent financial crisis, potentially slowing down the pace of that recovery.

We examine the extent to which the aging of the U.S. population creates headwinds for the stock market. We review statistical evidence concerning the historical relationship between U.S. demographics and equity values, and examine the implications of these demographic trends for the future path of equity values.

Demographic trends and stock prices: Theory

Since an individual’s financial needs and attitudes toward risk change over the life cycle, the aging of the baby boomers and the broader shift of age distribution in the population should have implications for capital markets (Abel 2001, 2003; Brooks 2002). Indeed, some studies attribute the sustained asset market booms in the 1980s and 1990s to the fact that baby boomers were entering their middle ages, the prime period for accumulating financial assets (Bakshi and Chen 1994).

However, several factors may mitigate the effects of this demographic shift. First, demographic trends are predictable and rational agents should anticipate the impact of these changes on asset demand. Consequently, current asset prices should reflect the anticipated effects of demographic changes. In addition, retired individuals may continue to hold equities to leave to their heirs and as a source of wealth to finance consumption in case they live longer than expected (e.g., Poterba 2001).

Foreign demand for U.S. equities might also reduce the downward pressure on asset prices. However, the effect is probably limited for two reasons. First, other developed nations have populations that are aging even more rapidly than the U.S. population (Krueger and Ludwig, 2007). Second, there is substantial evidence of home bias in equity holdings. Individual investors typically hold disproportionate shares of domestic assets in their portfolios. For example, in 2009, the foreign equity holdings of U.S. investors were only 27.2% of the share of foreign equities in global market capitalization. While the low level of international equity diversification is still not well understood (Obstfeld and Rogoff 2001), it suggests that foreign demand for U.S. equities is unlikely to offset price declines resulting from a sell-off by U.S. nationals.

Demographic trends and stock prices: Some evidence

To examine the historical relationship between demographic trends and stock prices, we consider a statistical model in which the equity price/earnings (P/E) ratio depends on a measure of age distribution (for another example, see Geanakoplos et al. 2004). We construct the P/E ratio based on the year-end level of the Standard & Poor’s 500 Index adjusted for inflation and average inflation-adjusted earnings over the past 12 months. We measure age distribution using the ratio of the middle-age cohort, age 40–49, to the old-age cohort, age 60–69. We call this the M/O ratio.

We prefer our M/O ratio to the M/Y ratio of middle-age to young adults, age 20–29, studied by Geanakoplos et al. (2004). In our view, the saving and investment behavior of the old-age cohort is more relevant for asset prices than the behavior of young adults. Equity accumulation by young adults is low. To the extent they save, it is primarily for housing rather than for investment in the stock market. In contrast, individuals age 60–69 may shift their portfolios as their financial needs and attitudes toward risk change. Eligibility for Social Security pensions is also likely to play a first-order role in determining the life-cycle patterns of saving, especially for old-age individuals.

Figure 1 displays the P/E and M/O ratios from 1954 to 2010. The two series appear to be highly correlated. For example, between 1981 and 2000, as baby boomers reached their peak working and saving ages, the M/O ratio increased from about 0.18 to about 0.74. During the same period, the P/E ratio tripled from about 8 to 24. In the 2000s, as the baby boom generation started aging and the baby bust generation started to reach prime working and saving ages, the M/O and P/E ratios both declined substantially. Statistical analysis confirms this correlation. In our model, we obtain a statistically and economically significant estimate of the relationship between the P/E and M/O ratios. We estimate that the M/O ratio explains about 61% of the movements in the P/E ratio during the sample period. In other words, the M/O ratio predicts long-run trends in the P/E ratio well.

Figure 1.

This evidence suggests that U.S. equity values are closely related to the age distribution of the population.”

Posted by Roger Montgomery, Value.able author and Fund Manager, 31 January 2012.

There was a lot of surfing on the Montgomery annual holiday so I thought I’d publish these thoughts on Billabong International for you.  Happy new year and all the best for 2012.

Billabong’s trading update in December attracted a great deal of attention – not only from shareholders who rushed the exits to sell their shares, but also from commentators who noted the result was a symptom of a cyclical and structural shift in the way retail goods, particularly fashion, is bought and sold in Australia.

That Billabong had downgraded its earnings guidance should not have come as a surprise: it is not the first time it has done this. In 2009-10, it announced a series of downgrades then failed to even meet the lowered figure in its full-year result. In 2010-11, it announced downgrades in October and December, then again in March 2011. Billabong is not a stranger to downgrades.

But downgrades aren’t the only reason I have never bought shares in this company. On a number of measures it has failed to live up to the high standards I set for a candidate to enter and remain in an A1 portfolio. On some of those measures it may be argued that Billabong has a “challenging road” ahead – a euphemism for the possibility of a serious structural change, which may include a capital raising, asset sales and/or write-downs.

Retailing in Australia has been doing it tough and I have written previously about the perfect storm facing conventional bricks and mortar retailers in this country.

Another retailer, JB Hi-Fi (ASX: JBH, SQR A3, $12.50), had been 5% of the Montgomery [Private] Fund portfolio until we sold out at $15.50. Our reasoning was simple: given present circumstances (the strong dollar and strong outbound tourism, and the consumer shift to online buying) and expectations for retailing (having spoken to many retailers recently), many retailers would have to revise their earlier outlook statements and this would produce lower future valuations.

Notwithstanding today’s speculation that the announced sale of Dick Smiths by Woolworths (ASX: WOW, Skaffold Quality Score B2, $24.45) will trigger a bid by the grocer for JB Hi-Fi, analysts’ forecasts are typically optimistic in the first half of the financial year (this year being no exception to that rule) and we should therefore be demanding much larger discounts and JB Hi-Fi’s shares were not offering that margin of safety.

I have also noted before that the deflation story – as explained by Gerry Harvey, who says selling plasma TVs for $399 last year means he has to sell three times the volume as last year to make the same money – would put pressure on profits because people already had enough plasma TVs.

Finally, we also believe ANZ’s reported profit growth last year, being dominated as it was by bad debt provisioning writebacks, meant that credit growth was non-existent. When you take away growth in credit card purchases that’s got to hurt discretionary retailers.

Billabong cannot be immune. And a long-winded, multipage analysis of the issues plaguing this company is not required because we’ve never suggested it as an investment.

Billabong reported that its first-half EBITDA in constant currency terms would be $4 million higher, but the company is a global retailer and its reported EBITDA is expected to be 20.8% to 26% lower. The company added that strong growth in constant currency terms in 2012 “is not expected”.

Tellingly, the company also noted that a full strategic review is required and a capital raising cannot be ruled out. The reason for this is simple: in light of deteriorating trading conditions the company has bitten off more than it can chew. This is best seen in the cash flow statement.

In 2010-11 Billabong reported profits of $119 million but cash flow from operations of just $24 million. Subtract dividends of $78 million (why pay dividends if you don’t have the cash?) and capex and investments of $266 million and you have a deficit that needs to be plugged with an equity raising or debt.

Turning to the balance sheet, you will find goodwill amounts to about $1.3 billion. That’s $1.3 billion of “oops-I-paid-too-much” and is more than half of the assets of the company. There’s also borrowings of $600 million and, despite the boost, the company is currently forecast to earn a return on equity of just 7%.

Given my bank is offering 90-day term deposits at 5.95%, I wonder how Billabong’s auditors can justify the carrying value of the goodwill on the balance sheet.

So there are two pretty good reasons you haven’t seen Billabong mentioned as a company to conduct more research on this year – or any year, for that matter.

Investing in 2012 could be largely about avoiding losses. To do that, you will need to watch out for companies whose structures are weak, whose performance is undesirable or whose price is too high. Obviously any stock that harbours all three conditions does not require my comment here.

Billabong’s debt has been rising, its return on equity falling, its balance sheet weakening and as an A4 on Skaffold’s quality scale, it was not investment-grade.

Skaffold’s Quality Score History for Billabong

If you are thinking about investing in retail in the coming year, be sure you know what to look for, even if mouth-watering prices are being offered.

Finally, for Skaffold member’s I hope you enjoy update 1.1 you will be receiving today, making Skaffold even more powerful and user friendly.  If you are not a member of Skaffold, what are you waiting for?  Skaffold is the best way we know of to deal with the market’s main risks;

Don’t miss an opportunity – every stock is covered and updated daily and automatically.

Reduce the risk of paying a high price for a stock – Skaffold’s intrinsic values ten years back and three years forward for every company.

Reduce the risk of buying the wrong company and suffering permanent capital loss – Skaffold’s Quality Scores, cash flow information and projected intrinisic values are updated in real time, keeping you abreast of vital changes to a company’s prospects as an investment candidate.

If you have been thinking about becoming a ‘Skaffolder’ there are few better times to get started than just before companies start releasing their important Half Year results.  Skaffold’s intrinsic values are updated live and daily so as company’s prospects are upgraded (or downgraded!) during reporting season, you are likely to find a multitude of opportunities for investigation.  Go to www.skaffold.com to get started just as reporting season takes off.

All the best for 2012.

Posted by Roger Montgomery, Value.able author and Fund Manager, 31 January 2012.

The banks are in the firing line again. A few months ago it was their record profits; today its talks of job cuts that dominate.  In November I noted that an industry insider had informed me that tens of thousands of jobs would be cut from financial services in 2012.  News today of job losses at one credit union suggests the process is underway.

But is something even bigger brewing?  Something that’s getting little or no headline attention? We believe so.  Collectively our banks made $24.26b in profits in 2011 (CBA $6.4b,NAB $5.5b, WBC $7b, ANZ $5.36b), but remember, banking is one of if not the most highly leveraged businesses on the Australian stock market. And being highly leveraged into any downturn means the economy can bite and bite hard.

While everyone’s focus is on cost cutting and net interest margins – so that the banks can maintain their profits – what are the numerous issues facing them:

• Elevated funding costs squeezing bank margins – Australian Financial Institutions source $310.5b in offshore borrowings.
• Declines in the share market impacting on wealth management profits.
• A higher frequency of natural disasters impacting insurance profits.
• The implementation of Basel III and higher capital requirements.
• Mortgage margins contracting given heavy competition for new loan business in a low growth environment.
• Low levels of system credit growth.
• Low levels of bad debt provisioning. Levels around pre-GFC 2008 levels and ratings agency Moody’s having serious misgivings about Australia’s housing market amid fears the property bubble will burst if Europe’s debt crisis is not contained.
• Analysts expecting house prices to drop further in 2012.
• Below 40% auction clearance rates across Australia.
• High historical levels of private and corporate debt levels.
• Falling property prices in China – the country’s Homelink property website reported that new home prices in Beijing fell a stunning 35 per cent in November from the month before.
• A broader economic slowdown in China and Japan as a result of Europe and US economies.
• Falling commodity prices for many of Australia’s key exports.

My view is that our highly leveraged banking system faces many pressures – from higher funding costs to increased unemployment (not just in the banking sector, some 100,000 jobs will be lost in retail alone) and the uptake of Basel III and that these pressures will see them needing to increase their capital. The canary in the coal mine is always of course bad debts.

Like my early prediction last year of a possible Qantas takeover, I may be wide of the mark, but I cannot rule out the possibility of the banks needing to raise capital in 2012.

If you work in the banking sector or are an avid follower of the Australian Banking system or know someone who is, I have a question to ask – despite the possible layoffs, what are you seeing? Clearly growth for banks is anemic and there are many headwinds to current consensus analysts’ earnings forecasts and their growth profiles. Are they achievable for our major banks in the coming years?

It is these forecasts that feed into valuation models which determine whether or not a margin of safety exists at current prices, so I’m throwing a call out to you. Do you agree with the current consensus view that jobs cuts are being made to preserve profits, or do you also see more to the story?

Posted by Roger Montgomery, Value.able author and Fund Manager, 11 January 2012.

This is a retail business that I’ve known for a long time, indeed in a past life I influenced one of its largest shareholdings.

At that time the company was leveraging its 90% brand awareness; increasing its return on equity every year, from 40% to ultimately more than 70%, without any debt; it was rolling out stores; it appeared to have perfected its buying strategy; and the share price had risen from $2.40 to a high of $18.60.

More than a year since I wrote that The Reject Shop shares were among the most expensive retail stocks and they touched their high, the performance has been somewhat unsurprising: declining to a closing low of $9 recently – a fall of just over 50%.

For those of you who have been fortunate enough to have been following us since 2009, you may recall in September 2009 when I wrote about the reasons why I decided to sell The Reject Shop:

“I can’t stop thinking that the value of the business just cannot rise at a fast enough clip to justify the current price. I really don’t like trading things that I have bought but I don’t think the value of the business can continue to rise indefinitely. With a share price of $13.45 (intraday today) and a valuation of $11.27, the shares are 24% above their intrinsic value. This combination of factors tells me we are safer in cash.”

Today the shares trade at about my current estimate for intrinsic value (see graph) of $9.22 and in anticipation of a possible big discount being presented, it’s worth reviewing our stance to determine whether we need to change it for this company.

Since I last wrote about the Reject Shop, a number of events have served to deliver sufficient concerns to market participants – analysts as well as investors – that they have turned their back on this once market darling.

First, the Queensland floods closed the Queensland distribution centre, seriously denting any supply chain efficiencies the company had built. Second, the company has doubled its equity base since 2006, from $26.6 million to $53 million, and this has been entirely due to the retention of earnings rather than less-desirable capital raisings. In the absence of an equivalent increase in profits, return on equity would be expected to decline. One way to stave off a decline in the all-important return on equity measure of performance is to increase leverage. The problem for the Reject Shop’s intrinsic value is that leverage has indeed increased – 34-fold – and yet return on equity next year is forecast to be lower next year than in 2006.

The Reject Shop still enjoys its high brand awareness but, as is typical in many store roll out stories, as the offer matures the later sites are less profitable than the early sites.

This doesn’t fully explain the fact that during a period in the economy where one would expect a bargain offering to shine, it hasn’t. Eighty percent of Australians still know the brand but I believe consumer experience and mismanagement has done it some damage.

According to one report, 20% of the population believe the company offers rubbish – cheap Chinese junk that quickly breaks after use and fills our tips. It’s the very reputation China itself is trying, but frequently failing, to shake off.

The other reason for damage to the brand is confusion brought on by mismanagement. Several years ago the average unit price was about $9 and basket size was $11, but over the years one cannot help but have noticed many higher-priced items creeping into the stores.

The Reject Shop was originally the place you went to for discounted seconds and end-of-line items. Under lauded retailer and merchant Barry Saunders, The Reject Shop successfully transitioned to a discount variety retailer, offering everyday lines at cheaper prices than the incumbents. Grey market (“parallel import”) Colgate toothpaste for $2 a tube and toilet paper for a few cents a roll ensured repeat business, higher inventory turnover and higher margins from consumers filling their baskets with other higher-margin items.

The company had successfully implemented the Walmart and Woolworths profit loop. Adding more expensive items, some in the $30, $40 and $50 bracket, confuses the offer and damages the brand. Simultaneously, inventory turnover falls and working capital costs increase.

Higher-priced items should at least partly explain why the company has not been performing well in the two-speed economy (I prefer to call it the one-cylinder economy) that would normally lend itself to the “bargain” offer. The other reason for the declining performance, including declining same-store sales growth, is the enthusiastic emergence of competitors. It’s really a second wave: The Reject Shop had put an end to Millers and the Warehouse Group previously. But now BIG W, Kmart, Target, Bunnings, a reinvigorated Mitre 10 and Masters will compete directly with The Reject Shop; you may have already seen some of their aggressive Christmas advertising.

If The Reject Shop’s offering had not been confused by the inclusion of higher-priced items, the company would have been in a much better position to defend its turf. The misguided product mix, however, appears to have left the gate open and the well-funded competitors have rushed in, as have Crazy Clarke’s, Sams Warehouse, Chicken Feed, GO-LO and more than 35 others. Of course these competitors will also compete for sites, potentially relegating The Reject Shop to less preferred sites or having to pay more for the best of the remaining locations.

That, and the possibility of a fall in the Australian dollar, represents the bad news. The good news is that The Reject Shop still has terrific brand awareness, many more stores to open, a reinvigorated marketing campaign and the reopening of the Queensland Distribution Centre ahead of the Christmas peak selling period.

On balance, if the company can hit its targets it could increase its intrinsic value by more than 15% per annum over the next three years and many believe the bad news and bearish case is factored into the share price. But I would like to see a decline in debt or a greater margin of safety or both, before buying its shares.

Rest assured that a rising tide (a rally in the stock market) will lift the price of the company’s shares. To be certain of a good return rather than be hopeful of an excellent one, we simply need a bigger discount, as the graph illustrates.

Posted by Roger Montgomery, Value.able author and Fund Manager, 3 December 2011.

I have just returned to the office after appearing on CNBC with my old friend Matthew Kidman.  We were in agreement on virtually all points (which perhaps surprisingly made the program very interesting).  If the market does indeed provide a once-in-a-lifetime opportunity, in the next 12 months, to buy excellent value industrial companies, then you may want to be aware of the companies that are either really poor quality or extremely overpriced now.

Stay tuned over the next few days, as I will be publishing our list of companies whose shares are in the hot seat.  Some of them may shock you.

If you would like to pre-empt the report, with some of your own suggestions, go right ahead and list them by clicking on the Comments link below.

Posted by Roger Montgomery, Value.able author and Fund Manager, 03 November 2011.

Congratulations are in order at our office.

Not to Forge or ARB for their full year results released today but to Chris B. our resident Albert Einstein, data integrity guru and valuation formula genius. Chris became a CFA today.

Well done Chris.

Thanks for all your hard work and keep it up – its working! Just look at the chart.

We are all excited to have you on the team.

(note:  Yes everyone the results ARE due to significant amounts of cash (inflows) that the process Chris helped developed DID NOT deploy into the market)  Well done Chris and on behalf of our investors thank you.

Posted by Roger Montgomery, 17 August 2011, with sincere thanks.

WARNING: This publication has been prepared by Montgomery Investment Management Pty Ltd ABN 73 139 161 701 AFSL 354 564 (“Montgomery”) for the purpose of providing general information, without taking into account your particular objectives, financial circumstances or needs.

An Information Memorandum (“Offer Document”) for the Fund(s) is available from Montgomery. Potential investors should consider the Offer Document in deciding whether to acquire, or to continue to hold, units in the Fund(s). Montgomery, its officers, employees and agents believe that the information is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors or omissions (including responsibility to any person by reason of negligence) is accepted by Montgomery, its officers, employees or agents. This online blog contains general information only and is not intended to represent general or specific investment or professional advice. The information does not take into account an individual’s financial circumstances. An assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial or other professional adviser before making an investment decision. No guarantee as to the capital value of investments in the Fund(s) nor future returns is made by Montgomery.

Have Australia’s lauded CEO’s earned a good reputation when it comes to the impact of their bigger-is-better ambitions on the shareholders for whom they work?

According to Richard Puntillo; “in theory, publicly traded corporations have shareholders as their kings, boards of directors as the sword-wielding knights who protect the shareholders and managers as the vassals who carry out orders. In practice, in the past decade, managers have become kings who lavish gold upon themselves, boards of directors have become fawning courtiers who take coin in return for an uncritical yes-man function and shareholders have become peasants whose property may be seized at management’s whim.”

When a listed company announces an acquisition, commerciality is often cited as the reason for failure to disclose the purchase price. But with Australia’s corporate graveyard littered with the writedowns of overpriced acquisitions past, it is about time companies treated their shareholders like kings.

I have long advocated the idea that companies should retain profits and reinvest them, provided they can achieve high rates of return on equity. The result? Much higher returns  – indeed returns that ultimately match the rate of return on equity being achieved by the company. But the rather worse-than-patchy record of Australian Merger & Acquisitions (M&A) in creating shareholder value, gives shareholders plenty of ammunition in their calls for companies to ‘hand the money back’.

Here’s a couple of examples…

Where, MQR: Montgomery Quality Rating; Value.able IV: Value.able Intrinsic Value; Today: Value.able Intrinsic Value as at today (5 May 2011); Ten Year IV Change: Ten year change in Value.able Intrinsic Value.

Foster’s

MQR: C5; Value.able IV 2001: $2.99;  Today: $3.50; Ten Year IV Change: 1.6%p.a.

Foster’s Share Price 2001 $5.71; Today: $5.51

Last week, Foster’s shareholders voted to spin off the company’s wine business. After buying Southcorp for $3.1 billion in 2005 (my valuation using the steps in Value.able was closer to $2.30 per share than the $4.17 Foster’s paid) Foster’s rejected a $2 billion private equity bid for its wine business, saying it “significantly undervalues” the Treasury Wine Estates.

When they bought Southcorp the execs were lyrical in their praise. Trevor O’Hoy said “The combination of our two great companies will create the world’s leading premium wine company”.

If you came to me to buy Southcorp in 2005, the year after it earned just $46 million in profit (the same profit as it earned ten years earlier by the way) and you wanted a margin of safety, I would advise that the right price to pay for Southcorp would be less than 65 cents. Try it yourself – plug 5% return on equity, $1.17 of equity per share and a payout ratio of just over 60 per cent into the Value.able formula. In 2005, when you came to me, the share price was $4.20 and using the price as a reference point, you would have thought I was crazy. The $3.5 billion in writedowns however since then, suggests it is the ‘too-cheap’ price for a copy of Value.able that is crazy!

PaperlinX

MQR: B2; Value.able IV 2001: $2.29; Today: $0.17; Ten Year IV Change: -23%p.a.

PaperlinX Share Price 2001: $4.93; Today: $0.28

On 9 September 2003, PaperlinX announced that it had purchased Buhrmann Paper for $1.1 billion. In June of that year Paperlinx’s share price was $3.77.

At the time, Ian Wightwick, Managing Director of PaperlinX said, “It is very pleasing that the hard work put in by our team undertaking due diligence has confirmed our initial view of the quality of Buhrmann’s Paper Merchanting Division business, its people and its assets. This business has great potential, and we are confident that the acquisition will deliver strong earnings per share growth for our shareholders.”

Ten days after the announcement the share price had shot up to $4.93. My Value.able Intrinsic Value estimation suggests it fell from $2.50 to $1.82! Nine hundred million was borrowed that calendar year and $150 million of capital was raised, to fund the acquisition.

For the year prior to the acquisition, PaperlinX earned $147 million. Since then profits have generally declined every year, and in 2009 PaperlinX lost $197 million and another $29 million in 2010. The share price has fallen from $4.93 to 28 cents today. Worse, there were 447.9 million shares on issue in 2003 and now there are almost 50% more.

AMP

MQR: A3;  Value.able IV 2001: $4.01; Today: $3.97; Ten Year IV Change: 0%p.a

AMP (adjusted) Share Price 2001: $13.90; Today: $5.29

AMP launched a cash and scrip bid for AXA Asia Pacific in late 2010. Under the deal with AXA’s French parent, AMP paid more than $4 billion for AXA Asia Pacific’s New Zealand and Australian businesses. The deal valued the entire AXA company at $13.3 billion, but the Value.able intrinsic value of AXA is significantly lower.

AMP bid about $5.40 per share. And just like Southcorp shareholders, AXA shareholders wanted a higher bid. Well of course they did, and as I have said previously, I would rather receive a few million more for my house too. But AXA’s performance doesn’t justify it.

AMP’s chief executive Craig Dunn said that the deal would create an effective competitor to the big four banks and makes AMP the biggest player in all segments of Australia’s $1.2 trillion wealth management sector with 20 per cent market share.

In a bout of déjà vu (reminiscent of PaperlinX), AMP’s shares rallied after the deal was announced.

According to analyst estimates at the time, AXA would generate a return on equity of about 13 percent over the next two years. With the exception of the 2008 loss, the return on equity for the last ten years has ranged between 6.8% in 1999 and 27% in 2003. Based on the forecast ROE and a payout ratio of between 61% and 67%, AXA’s 2010 equity of $2.58 per share is worth a little more than $3.00 per share. At the time of the bid, AXA’s shares traded at $5.84.

When Oxiana and Zinifex merged to form OZ Minerals, the market capitalisation of the two individually amounted to almost $10 billion. Today the merged entity has a market cap of $4.6 billion.

The above examples are not rare. With more space, we could go through many, many more.

Overpaying for assets is not a characteristic unique to ‘mum and dad’ investors. CEOs in Australia have a long and proud history of burning shareholders’ funds to fuel their bigger-is-better ambitions. PaperlinX, Fairfax, Foster’s – the past list of companies and their CEOs that have overpaid for assets, driven down their returns on equity and made the Value.able value of intangible goodwill carried on the balance sheet look absurd, is long.

Nothing gets the blood racing more than a takeover and when blood leaves the head for other regions, common sense usually follows. You should be on your guard when your company announces an acquisition.

Posted by Roger Montgomery, author and fund manager, 3 May 2011.